Retired Americans' health care

Clearly unhealthy

Public-sector employers count the cost of their health-care promises

THESE days, Americans have many reasons to worry about how they will make ends meet when they retire. Social Security is said to be teetering; corporate and public pension plans are saddled with big deficits. The fastest-growing problem, however, is that rocketing costs are making it increasingly hard for employers to pay for the health care that many of them provide for retired staff. Many companies—think of General Motors—are finding the sums unpleasant. And following an accounting rule finalised last August by the Government Accounting Standards Board (GASB), the standard-setter for America's state and local governments, public-sector employers are also trying to come to grips with the cost of their promises.

Currently, nearly all governments operate on a “pay-as-you-go” basis. They dole out cash to pay for the medical care of those who have retired, but set none aside for future obligations. Their accounts have mirrored this, reflecting only current health-care expenditures and not the cost of promises that are yet to come due. This, critics say, lets governments make promises without counting the cost to be borne by future taxpayers.

The GASB's new rules compel America's 84,000 state and local government entities, including public hospitals and schools and fire and police departments, to put a value on the “other post-employee retirement benefits” (OPEB)—consisting mostly of health care—they promise to employees. They will also have to record an expense (the “annual required contribution”) for the amount they would need to stash away to fund this long-term liability fully over 30 years. Actuaries estimate that this contribution could be five to ten times current annual outlays for retirees' health care. Unfunded contributions will appear as a liability on balance sheets. The rules will be phased in over three years, starting in fiscal years beginning after December 15th 2006 for the biggest governments.

The idea, says Karl Johnson of the GASB, is for the new rules to make the cost of retiree-health obligations clearer and thus keep governments from making over-generous promises. “These costs were always there,” he says. “They just weren't disclosed and often were not even measured.” The private sector has had similar rules since 1992. But the effect on the public sector could be much bigger, because government employers are likelier to provide health-care benefits to retired staff (77% of “large” governments do so, against 36% of comparable companies, according to the Kaiser Family Foundation). Public-sector benefits also tend to be more generous.

The unfunded liabilities that will come to light are likely to be huge, dwarfing many pension deficits, because pensions are pre-funded. Mercer Consulting reckons that governments that have not set aside money for future obligations will face liabilities 40-60 times the current annual cost of retirees' health care. So California, for instance, which allocated $895m for retirees' health care in the 2005-06 budget, could have an unfunded OPEB liability of around $36 billion. North Carolina estimates its liability at $13 billion-14 billion. The Los Angeles Unified School District puts its liability, at the low end, at $5 billion, equivalent to 80% of its general-purpose operating budget. Keenan & Associates, a consulting firm that works with California's school systems, estimates that the unfunded liability for the Golden State's schools and community colleges is $22 billion.

If governments do nothing, their credit ratings could be damaged and their cost of borrowing could rise. Joseph Mason of Fitch, a rating agency, says that his firm will look not only at the big unfunded liability numbers but also at the steps governments take to manage their OPEB obligations. “With health-care costs spiralling and workforces ageing,” he says, “standing still isn't a viable option.”

Employees worry that governments will cut health benefits, as the private sector did when its rules were introduced. Some firms dropped health-care coverage for new employees. Back in 1988, according to Kaiser, 66% of big firms' health-care budgets went to retired employees compared with little more than a third today.

OPEB promises enjoy less legal protection than pension promises, some of which are even guaranteed in state constitutions. Even so, they may be hard to cut. The public sector is heavily unionised, so hacking at benefits could mean difficult negotiations or strikes. It would also damage morale and recruitment.

Governments are therefore scrambling to find other, politically more palatable options. Those in the best financial health may fund their OPEB promises in advance. Others are exploring milder ways of cutting costs. For instance, North Carolina, which gives its workers health benefits for life after only five years on the job, is considering lengthening the qualifying period. Some governments want employees or Medicare to foot more of the bill.

Several California school districts are talking to Wall Street about issuing bonds, as some states have done to shore up ailing pension plans. The idea is that, as long as the investment returns on the money raised are higher than the interest rates paid on debt, everyone gains. But this gamble can backfire, as it did for New Jersey, which issued pension bonds in 1997 and suffered when the technology bubble burst. There is no easy fix.